When Genius Failed: Lowenstein Talks LTCM

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This article was originally published on RealMoney.com on November 11, 2000.

In the fall of 1998, whispers began running through the canyons of Wall Street about a hedge fund in trouble. Big trouble. Investments had gone awry and a massively leveraged portfolio teetered, and, some say, the financial system teetered along with it.

We are, of course, talking about Long Term Capital Management, the hedge fund run by Nobel prize laureates and Wall Street geniuses. Its demise drew in Federal Reserve officials, big brokerage firms and well-known personalities such as Warren Buffett and George Soros.

Roger Lowenstein, one of the finest financial journalists in the country, has offered insight into the Long Term Capital debacle with his recent book, When Genius Failed. It's a crackling good read, and Roger's an interesting student of the financial world.

Brett D. Fromson: First of all, just how hard was it to do this book with John Meriwether himself not cooperating?

Roger Lowenstein: It was really hard. For one thing, my own previous comparable experience was doing the book with Warren Buffett. And that might seem analogous because Buffett also did not cooperate. There was a big difference, though, because Buffett was the story of a winner, and all of the concentric circles around Buffett were basically eager to cooperate, because everybody likes to be part of the story of a winner. This was the story of titanic losers.

Brett D. Fromson: How about the clients?

Roger Lowenstein: Nobody wanted to go on record. Nobody wanted to be part of this story. The employees themselves were initially totally off limits, because they had all signed confidentiality agreements. There was a very low proportion that ultimately decided to talk anyway, God bless 'em, but it was a tough book.

Brett D. Fromson: Right. Well, you must be glad it's over.

Roger Lowenstein: Yes. You're always glad when the book is over.

Brett D. Fromson: What about just the technical issues? A great deal of the book is somewhat more complex than equities. You're talking about credit spreads, swap spreads and motility data.

Roger Lowenstein: Right. That was a struggle, too, an internal struggle the whole way about how much to go into. Basically, I kept cutting back and cutting back and what I tried to do was give the reader a good idea of what they were betting on. For instance, if they were betting on higher volatility in the stock market or lower volatility in the stock market. But -- though very sparingly, and sometimes not at all -- on how they would execute that, or which 18 trades would arrive at that bet. And the final product had much less of that than the first draft. If there had been a future draft, there would have been less. Every time I went over it, I just skimmed some of that out.

Brett D. Fromson: Did you finally get some of the partners to speak with you? It seems that you did.

Roger Lowenstein: Let's see, it's in the book that Eric Rosenfeld cooperated in an informal, sporadic way and not in a formal or open-ended sense. I did reach people at all levels of the firm.

"This was the story of titanic losers."

Brett D. Fromson: Is this a morality tale? How did you come to understand the story at the end?

Roger Lowenstein: There are two morals in it. One is the tale about the limitations of human intelligence bordering on genius and almost the temptations and the risks of extreme intelligence when it's not tempered by judgment. Others who might have a different perspective than the three or four or 12 geniuses themselves. And as it relates to the financial markets specifically, I think it's a cautionary tale about inherent limits of models, of historical lookbacks.

Brett D. Fromson: Now thinking about LTCM, I saw a piece you wrote recently in the Times main section. Why are you concerned with the lack of regulation over hedge funds?

Roger Lowenstein: I'm not really concerned with a lack of regulation over hedge funds, because unless we've accepted that the Fed is going to sponsor a bailout every time there's trouble ... but I assume we haven't gotten there yet. I'm concerned about the lack of required disclosure over derivatives, regardless of who does them. The reason I am, if you look at the balance sheet of a healthy traded bank or a bank with insured deposits, you can get a pretty good idea of their liabilities. It's still their derivative exposures that are really shrouded in a haze for almost any outsider who looks, and the obligations are just as great.

Brett D. Fromson: The obligations of the institution?

Roger Lowenstein: Yes. These are contracts that intertwine really all institutions. There's potentially no limit on the size, because if you need little or no cash to make these obligations, you and I simply agree to exchange an amount of funds according to what happens in the market, whereas, if you decide to buy a security, you have to put down at least margin.

Brett D. Fromson: The derivatives, in a sense, are pure credit.

Roger Lowenstein: They're bets.

Brett D. Fromson: You believe that I will pay you back because I tell you that.

Roger Lowenstein: If you agree to pay me a certain amount of money for every run that the Red Sox score this season and we have no idea how many runs they're going to score, and I have no idea if you made the same bet on the Indians and the Tigers, too.

Brett D. Fromson: And, ultimately, the only guarantee you have that I'm going to pay you is that I tell you I'm going to pay you.

Roger Lowenstein: Right.

Brett D. Fromson: Or you can sue me in court.

Roger Lowenstein: Right. But it hasn't cost you anything to make that bet. So that's my concern.

Brett D. Fromson: Now, with regard to disclosure on derivatives, the bank regulators do see some information themselves because there's a difference between bank disclosure and brokerage firm disclosure.

Roger Lowenstein: Yes, they do see some and investors see some, but it's not broken down for the average or even the pretty sophisticated investor who really understands. It's not in a form that the average investor could say, "OK, if rates in Germany do this, this institution is going to have this much exposure." There are also no limits on that exposure. Don't forget, a regulated bank has limits on the loans it can make as a portion of its capital. Why not with derivatives as well?

Brett D. Fromson: Are there any regulations on banks regarding their derivative positions?

Roger Lowenstein: No.

Brett D. Fromson: Now the Securities & Exchange Commission has agreed to accept a voluntary disclosure from the big Wall Street houses, I believe. But it's not required. The SEC has not pushed that hard on that. Frankly, none of the financial regulators have pushed that hard on disclosure in terms of making it required.

Roger Lowenstein: Derivative or hedge fund disclosure?

Brett D. Fromson: Derivative.

Roger Lowenstein: Yes, there is some, there certainly is some derivative disclosure required. The SEC has a pretty full plate. The Federal Reserve has been champion of the need that derivative transactions introduced, and has been pushing to relax requirements.

Brett D. Fromson: Now doesn't this attitude on the part of the Fed also reflect a belief in markets as potentially perfect vehicles? Which is funny, coming from a regulator.

Roger Lowenstein: Yes, well certainly as self-correcting vehicles. Greenspan was asked about hedge fund risk shortly before LTCM went under and he said that these funds will be regulated by the people who finance them. And that was an astonishing comment, because as it happened, the case of LTCM was nothing but a demonstration that the banks exercised no control at all. They created the problem.

"They apologized, but I never got a strong sense of what they were apologizing for."

Brett D. Fromson: The irony there is that the Fed, at the same time that it's arguing and self-correcting aspects of the financial markets, itself has to organize the corrective mechanism.

Roger Lowenstein: I guess my feeling is, where would you rather have the government? Would you rather have them jumping in when there's a problem, or would you have them mandating enough sunlight so the problems are less likely to occur? I mean, I would say obviously the latter. Disclosure works pretty well. I mean, if the shareholders of J.P. Morgan ( JPM) and Merrill Lynch and Goldman Sachs ( GS) either know enough to get nervous when those institutions extend too much credit to hedge funds, you're going to see those institutions extending less credit to hedge funds. That system's not perfect; people will still make mistakes.

Brett D. Fromson: Since Long Term Capital's downfall, has there been any improvement in derivative disclosure?

Roger Lowenstein: No. Greenspan has continued to push for a relaxation.

Brett D. Fromson: Meanwhile, the SEC, I believe Arthur Levitt personally, expressed the desire to try to do something, but I always had the feeling that he never really could make it happen, he just didn't have the political support.

Roger Lowenstein: Yes, I think the Fed has taken the lead on this one.

Brett D. Fromson: I think they've also, to a certain extent, elbowed the SEC out of the way, because even with regard to disclosure for the brokerages, where you would think the SEC might have grand purview, the SEC I think agreed to essentially voluntary disclosure. Now, what do you think that the partners at LTCM learned, if anything?

Roger Lowenstein: That's a good question. They did a long roadshow after The Event, as they call it.

Brett D. Fromson: The Event? Great euphemism.

Roger Lowenstein: Yes, it's a great euphemism. After Waterloo, they visited all their investors explaining, in their view, what had happened and thus preparing the way to raise new money. A dream that was living from the moment they went down, even before they went down, they were thinking of resurrecting themselves with a new fund and the gist from many retellings, and that is to say, conversations with the people who heard their pitches, was that they had been done in by a perfect storm, a 100-year storm, and also by people who had front-run them. They apologized, but I never got a strong sense of what they were apologizing for.

Brett D. Fromson: Or an admission of mistakes.

Roger Lowenstein: Yes, and they were somewhat diffident on the issue of whether they had been deleveraged. That was a sticking point with them.

Brett D. Fromson: In what way?

Roger Lowenstein: They said leverage isn't the right measure of risk.

Brett D. Fromson: What is?

Roger Lowenstein: You know, they would say volatility around the mean, which I think is one of the things that got them into trouble. Because volatility is a backward-looking measure, it doesn't tell you what volatility tomorrow is going to be. I think they certainly realized that their position size was too big. Recently, of course, Meriwether came out and said the strategy was fundamentally flawed. That's a pretty interesting remark. It's just not in agreement with what they've been saying for two years to many, many people.

Brett D. Fromson: Basically flawed in what regard? Did he say?

Roger Lowenstein: I believe he referred to position size, I believe he did refer to leverage, but you better check. I don't know the extent to which this was a change of heart, the extent to which it was PR. I certainly called him on it when I learned about the "new openness," but apparently the window had closed.

Brett D. Fromson: Question...

Roger Lowenstein: Did they? What had they learned? They learned some humility from this, yes.

Brett D. Fromson: Not to put too fine a point on it, but they lost a lot of money that wasn't theirs. That should chasten a person.

"In two days in August and September, each of two days, they lost more than $500 million."

Roger Lowenstein: Yes. They also lost a lot of money that was theirs. They lost about $4.5 billion at the top. Almost $2 billion was theirs. Losing other people's money chastens you. Losing your own chastens you, too.

Brett D. Fromson: Did they admit that maybe some big position size was a problem? Did anyone come back and say we actually were unable to manage the risk, the volatility around the mean and we were being paid to manage that volatility around the mean and you know what? We failed. Or would you disagree that they failed to manage the volatility? Or would you say it's just unmanageable?

Roger Lowenstein: They would say that. To me it's unmanageable.

Brett D. Fromson: They would say what?

Roger Lowenstein: They would say they failed. Obviously, something failed. But this expression, managing risk, I don't know what it means. It's like managing the speed of a snowball rolling down in an avalanche. I mean, once it rolls, you can talk all you want about managing, but you're going downhill. They had a program that said they were unlikely to lose more than $40 million or so on any given day. In two days in August and September, each of two days, they lost more than $500 million.

I believe one lesson for them was the apparent failure of diversification. It's strange that it would have been such a lesson, because in 1987, being in different types of stock or being in stocks in different countries wasn't going to help you. When people get scared, when they get really scared ... that happens in financial markets.

Brett D. Fromson: Although bonds would have helped you in 1987.

Roger Lowenstein: Bonds would have helped.

Brett D. Fromson: Treasuries rallied.

Roger Lowenstein: Yes, they did.

Brett D. Fromson: And they did here, as well.

Roger Lowenstein: In general, when people start to panic, they're not discriminating. That's almost the definition of panic. The other thing -- and I think some of them still disagree with me on this, David Mullins does when we talk -- it seems that not only did diversification fail, but they were less diversified than they seemed to think.

Brett D. Fromson: How were they positioned going into this crisis?

Roger Lowenstein: They had a huge bet on swap spreads in Europe and the U.S. and basically on swap spreads narrowing.

Brett D. Fromson: Swap spread, again, is essentially the difference between the rate of interest normally charged in a rather conventional, sort of thick-loading derivative swap and Treasuries?

Roger Lowenstein: The swap rate is the amount someone charges to switch from float and fixed. The difference between that and Treasury is the spread.

Brett D. Fromson: In times of fear that spread widens, meaning it's hard to say who's the better credit in a panic.

Roger Lowenstein: It's cumbersome to say that the spread rate is overpriced at default risk and therefore I'll short that and buy a bunch of risky credits. It's cumbersome and you sort of have to wait a long time until people realize that the market's overpricing credit risk. For instance, if the market is overpricing the default risk of Amazon.com ( AMZN) , you can just buy the bonds, say, because they're so cheap, and as the bonds come in, you'll make money. It's more cumbersome, and there are great debates about what the spread precisely represents, but it's certainly true that as fear grows, it grows and vice versa.

They had that bet in the U.S., they had that bet in England, and both of those bets were bets on the perception of risk and fear and were false. The bet in Europe was mitigated somewhat because they were betting the other way in Germany. They had an analogous bet on equity volatility, which is to say the volatility of stock markets, and they were betting that the amount that a stock market moved around, the volatility would lessen or that the perceived future volatility of risk would drop. These are all bets on lessened risk perception, lessened volatility. They took a riskier side of the Russian bond spectrum, the riskier side of the mortgage-backed spectrum and the riskier side of the junk bond spectrum.

Brett D. Fromson: They were betting on a reduction in volatility.

Roger Lowenstein: They were betting that the world would look a little rosier.

Brett D. Fromson: And they were wrong.

Roger Lowenstein: And in each of these things, with the exception of, say, the German case where the hedge was in England, most of their bets were bets that the world would seem a tamer, safer, less volatile place. It's certainly true that some of the individual bets had little to do with others. But, when people decided that they no longer knew what the boundary of risk was, they just wanted out of risk, they were on the wrong side of all those bets.

Brett D. Fromson: Why did LTCM blow up, whereas none of the big derivative dealers blew up?

Roger Lowenstein: You mean like Morgan?

Brett D. Fromson: Morgan, Goldman, some of the Swiss banks.

Roger Lowenstein: Well, that was LTCM's only business. I think J.P. Morgan was a better-managed firm. Goldman was up to its neck in trading, and it lost a billion dollars, but it was 1 billion, not 4 billion, and they had other businesses, it was more diversified. Merrill also lost a billion or so in bonds, but they were obviously more diversified.

"So, $1 from start to finish turned into 33 cents at a time when the stock market was doubling."

Brett D. Fromson: Do you think the bank regulations caused them to be not only less monomaniacal in the business focus, but also to hold more capital relative to position sizes, or were they equally leveraged?

Roger Lowenstein: I don't know the answer to whether they were equally leveraged, but people who are running public companies are much more cognizant of the riskiness of the trading business. Sandy Weill hated that business. He was very pressured. He got Salomon Smith Barney out, or halfway out, but they still had big losses.

Brett D. Fromson: Out of Russia?

Roger Lowenstein: Out of Russia, and out of funds that they closed down, divesting their U.S. fixed-income arbitrage group. He and Jamie Dimon did it at Salomon Smith Barney. They did still have heavy losses, but it could have been a lot worse. Those guys want regular, rising profits every quarter, which you don't get in this business. Goldman was preparing for its IPO, and the extent to which they should rely on trading has always been an issue there.

But, if you looked at that question in a different light, as a company that is going public as soon as LTCM would have, Merrill thought it had no exposure. Merrill was shocked and a lot of heads rolled in bond trading afterwards. It has based its business really on the idea of having no exposure. The problem is, anybody who holds an inventory in bonds is going to hedge them in Treasuries. So they were sort of inadvertently in the LTCM trade.

Brett D. Fromson: In what sense?

Roger Lowenstein: In the sense that they were long riskier stuff and short Treasuries.

Brett D. Fromson: Their relationship with LTCM was that they were an investor, or a lender, or both?

Roger Lowenstein: They were both. I mean, they were a supplier of credit, a supplier of swaps and they were the firm that had taken LTCM on the road. They had done the dog-and-pony show and raised the first billion, but David Komansky had been offered the chance to become a big investor, put $100 million in, and he said, "No, thanks." So, the basic answer to your question is yes, all these firms, public firms, either because of what they disclosed or because of what they knew they would have to disclose in the event of a lawsuit, had different mindsets about taking these risks.

Brett D. Fromson: Lower tolerance?

Roger Lowenstein: Yes.

Brett D. Fromson: In retrospect, looking at the returns for the risks, I know that they were fantastically successful when they were successful, but overall, it doesn't look like the returns were that good.

Roger Lowenstein: You mean the cash returns or the overall returns?

Brett D. Fromson: I mean the overall returns. I want to know what you think, because on the one hand they certainly made a ton of money using enormous leverage, and then they lost it all.

Roger Lowenstein: If you look at the cycle, if you put a dollar on LTCM, it rose, before fees, to about $4.11 -- it was in the book but I think that was the exact figure, at the peak -- then it fell to about 32 or 33 cents. So, $1 from start to finish turned into 33 cents at a time when the stock market was doubling.

Brett D. Fromson: Is that roughly what the stock market did over this period of time?

Roger Lowenstein: Yes.

Brett D. Fromson: It doubled?

Roger Lowenstein: Yes.

Brett D. Fromson: And this is the period of time from 1994 through when?

Roger Lowenstein: 1994 to 1998. The end of 1998.

Brett D. Fromson: Great time to be in stocks. Pretty good time.

Roger Lowenstein: Yes, it was a great time. It was a good time to be in bonds, too. It was a great time to be in anything but LTCM. And if you'd done it on a fee basis, you went from $1 to close to $3 then down to 23 cents. You never come back from that because the next year they made 10%, and that was the 32 cents back to 36 cents and 23 cents back to 25 cents. You never come back from that loss. Many outside investors were cashed out against their will, before the fall. But many of the outside investors made money.

Brett D. Fromson: Ironically.

Roger Lowenstein: Very ironic. "They're not super-rich any more. Now they're just plain, ordinary rich."

Brett D. Fromson: They must have been complaining that they were booted out.

Roger Lowenstein: They were screaming. They were jumping up and down and screaming. Then there were a few, you know, Jimmy Kane was one at Bear Stearns, who prevailed in the long term having special status to leave more of the money in. He ended up one of the losers.

Brett D. Fromson: Because Bear was their clearing broker.

Roger Lowenstein: Bear was their clearing broker.

Brett D. Fromson: So he had...

Roger Lowenstein: He was favored, yes.

Brett D. Fromson: I can think of a few things to say about being favored in that particular way.

Roger Lowenstein: He'll survive.

Brett D. Fromson: I'm sure he will. How much money did the partners end up making or losing? I mean, at the end of the day, did these guys basically blow it all?

Roger Lowenstein: They blew it except for the tiny tip of the iceberg. They had $1.9 billion in the fund, the 16 of them, the great bulk of that held by four or five people -- Larry Hillebrand, Meriwether, probably Victor Agani and Eric Rosenfeld. Those four, then Greg Hawkins and everyone else and it was a steep slope down. Hillebrand had close to half a billion and these others had low hundreds of millions.

Brett D. Fromson: So they put this money, this $1.9 billion with the equity at the peak...

Roger Lowenstein: Yes. And that was all lost.

Brett D. Fromson: Right. This was taken out of salaries or bonuses or cash?

Roger Lowenstein: Yes, they used the partnership as a checking account. They wrote money against, they had virtually all of their investments in the fund.

Brett D. Fromson: Right.

Roger Lowenstein: Larry Hillebrand, as best as I can tell, was broke and had to rely on his bank. His wife is on Wall Street and she has ample funds in her name and they still live well. The others weren't leveraged personally to the same degree at all.

Brett D. Fromson: What about Meriwether?

Roger Lowenstein: No. I'm not aware that he had any personal leverage. And he still has his estate.

Brett D. Fromson: He's back in business.

Roger Lowenstein: He's back in business. They haven't disputed the figure of losing 90% or more of their money. It's something in the order of hundreds of millions. I don't know the exact figures.

Brett D. Fromson: So, from the average person's point of view, they're still quite comfortable.

Roger Lowenstein: No, they're still totally comfortable. But they're not super-rich any more. Now they're just plain, ordinary rich.

Brett D. Fromson: In the sort of $5 million to $20 million range.

Roger Lowenstein: They may have less.

Brett D. Fromson: Meriwether's new fund -- all the same cast and crew?

Roger Lowenstein: No. There was a fair amount of animosity among the partners when they split up. If you weren't part of that core group ... it wasn't something you got promoted into. I mean, this group had been together at Salomon for so long. There was antagonism towards a bunch of the other partners, towards Hillebrand and Agani, both because they were the predominant influence in the trading book and because their style didn't tend to be open to dissension. They just weren't open to hearing other ideas, particularly ideas that they were taking too much risk, and so on.

The partners all shared blame equally because they all ran the risk management committee. So it's not to say that Hillebrand had the power to override them but the cohesiveness broke up. Myron Sholes is sort of a hot-tempered Nobel laureate and has no love lost for Larry Hillebrand. Jim McIntee was a long close friend of John Meriwether and urged him to lighten up, but was ignored. He's gone off on his own now.

Brett D. Fromson: Let me ask you, I wrote a column about Meriwether's new fund having gotten offered a prospectus, and I was looking through it. The reason I wrote the column was that I was just struck by how much they were going to charge people for what they said would be 15% to 20% returns.

Roger Lowenstein: Yes.

"You can be illiquid and heavily exposed, or you can be leveraged. But if you're both, all it takes is one bad day and you're dead."

Brett D. Fromson: And I thought it was amazing that they wanted 2%, close to 20% of the profits in order to get someone between 15% to 20%. And I thought that was a shocking statement of continued arrogance. These people are not known winners.

Roger Lowenstein: Right. The 20% is standard, but the 2%, obviously, is not. Their business is a high-expense business for hedge funds.

Brett D. Fromson: Because of what was trading...

Roger Lowenstein: What was trading, because of the computer models, the international -- they have a staff now, of 55 people. I have friends who run hedge funds with about as much money and they have...

Brett D. Fromson: Ten people, maybe?

Roger Lowenstein: Ten, no, it's maybe three guys and a wall, and somebody answering the phones. But 55? So the 2%, I'm not sure.

Brett D. Fromson: What's your takeaway from the role of the Fed here for investors? What's the lesson for investors, that the Fed will come in a crisis and bail out the big boys in order to save the rest of us?

Roger Lowenstein: I think the Fed was just very uneasy about its profile. But I don't want to be the one to tell people, "Well, go jump off a building, the Fed will be there to hold your hand."

Brett D. Fromson: And last question: What did you learn yourself about the nature of financial markets from looking at this so closely?

Roger Lowenstein: Long term? When they told the bank we want better terms than anybody else and we're going to split up our trades so that none of you know where we're going, the banks just fell on themselves to be their partners. Then when they needed help, when they returned capital, people didn't stand it. Then when they needed help, nobody would answer their calls. That line of Jimmy Breslin's, "Power is the reputation of power" -- in financial markets, success is the reputation of success and then, if you accept them as a herd... It's so susceptible to flights of panic.

It gives you a new understanding of the risk of leverage because it means an exposure. It means you can't just count on being right at the end of the day. You have to be right enough, every day, because if you're leveraged, you cannot get to the long term. You can be illiquid and heavily exposed, or you can be leveraged. But if you're both, all it takes is one bad day and you're dead.

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